Courage Vs. Comfort

Philosophers have long argued that courage is the most essential human virtue because, without courage, all other virtues lie in jeopardy. Remarkably, the theorizing of ethicists has an implication for practical portfolio management.

We can illustrate this with a simple example in Exhibit 1. It’s Dec. 31, 1999, and a professional investor is considering buying four different stocks for his clients’ portfolios. He obtains (never mind how; read the papercorrect data on the future volatility of the four candidates. All four possible purchases are more volatile than the market as a whole, but stocks A and B appear especially so.

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Our investor has confidence in the analysts who recommended all four investments and realizes that volatility is the price you sometimes must pay to earn the stock market’s long-run returns. But he’s also mindful that positions in stocks A and B, in particular, might produce some very uncomfortable client meetings. When the $1,000 he invested in stock A is worth only $275, will he still have confidence in his analyst’s recommendation? More urgently, will his clients still have confidence in him? The volatility data make it clear that, regardless of the long-run outcome, stocks C and D will be much more comfortable holdings than A and B.

And this, as Exhibit 2 makes clear, is the problem. Stock A is Apple, which turned out to be the best performer in the S&P 500® for the 20 years ended December 2019. Stock B is Amazon, which lagged Apple but still beat the market handily. Stocks C and D, the comfortable choices, both underperformed the S&P 500. Pity our poor manager: the stocks that would have been easy to hold, and make for relatively stress-free client meetings, ultimately underperformed. The two winners, which would surely have enhanced his reputation as an astute stock picker, would have done the opposite.

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